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CHAPTER 15
International Economic Policy
15-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• How has the world organized its
international monetary system?
• What is a fixed exchange rate
system?
• What is a floating exchange rate
system?
• What are the costs and benefits of
fixed exchange rates vis-à-vis floating
exchange rates?
15-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• Why do most countries today have
floating exchange rates?
• Why has western Europe recently
created a “monetary union”--an
irrevocable commitment to fixed
exchange rates within western
Europe?
• What were the causes of the three
major currency crises of the 1990s?
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Gold Standard
• Before World War I, nearly all of the
world economy was on the gold
standard
– a government would define a unit of its
currency as worth a particular amount of
gold
– the currency was convertible
• could be converted into gold freely
– the currency’s price in terms of gold was
its parity
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.2 - Growth of the Gold Standard
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The Gold Standard
• When two countries were on the gold
standard, their nominal exchange rate
was fixed at the ratio of their gold
parities
– at World War II parities
• the U.S. dollar was equal to 1/35 of an ounce
of gold
• the British pound sterling was set to equal
1/15.58333 ounces of gold
• the exchange rate of the dollar for the pound
was £1.00=$2.40
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Gold Standard
• Example of currency arbitrage
– the U.S. government is willing to buy
gold at $35 per ounce
– the British government is willing to buy
gold at £15.58333 per ounce
– the pound trades for $2.64 (10% higher
than the ratio of the gold parities $2.40)
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Gold Standard
• Someone with an ounce of gold could
– trade it to the British Treasury for
£15.58333
– trade those pounds for dollars in the
foreign exchange market and get $38.50
– trade the $38.50 to the U.S. Treasury for
1.1 ounces of gold
– repeat the process as quickly as possible,
making a 10% profit each time the circle
is completed
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.1 - How to Profit in the ForeignExchange Market
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Weaknesses of the
Gold Standard
• The gold standard tended to be
deflationary
– under some circumstances, it pushed
countries to raise their interest rates
which reduced output and increased
unemployment
– it never provided a countervailing push to
other countries to lower their interest
rates
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Weaknesses of the
Gold Standard
• If the exchange rate is floating,
foreigners’ domestic currency
earnings must be used to buy exports
or to invest in the home country
NX  NFI  0
• The exchange rate moves up or down
in response to the supply and demand
for foreign exchange in order to make
it so
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Weaknesses of the
Gold Standard
• Under a gold standard, foreigncurrency earnings can also be used to
purchase gold from the foreign
country’s Treasury
NX  NFI - FG  0
• If a country’s net exports plus net
foreign investment are less than zero,
its Treasury will find itself losing gold
– the country’s gold reserves shrink
15-12
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Weaknesses of the
Gold Standard
• If a country’s gold reserves are
shrinking, it has a choice
– abandon the fixed exchange rate system
– make it more attractive for foreigners to
invest by raising domestic interest rates
• puts contractionary pressure on the economy
• Countries gaining gold face no
incentive to lower interest rates in
order to stay on the gold standard
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Collapse of the Gold
Standard
• The gold standard was suspended
during World War I
• After the war ended, politicians and
central bankers sought to restore it
– they believed it was an important step in
restoring prosperity
• After the Great Depression began, the
gold standard broke apart
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Collapse of the Gold
Standard
• Four factors made the gold standard a
less secure monetary system
– everyone knew that governments could
abandon their gold parities in an
emergency
– everyone knew that governments were
trying to keep interest rates low enough
to produce full employment
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Collapse of the Gold
Standard
• Four factors made the gold standard a
less secure monetary system
– after World War I, countries held their
reserves in foreign currencies rather than
gold
– the post-war surplus economies did not
lower interest rates as gold flowed in
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Collapse of the Gold
Standard
• As soon as a recession hit,
governments found themselves under
pressure to raise interest rates and
lower output
– could either stay on the gold standard
and face a deep depression or abandon
the gold standard
– the further countries moved away from
their gold-standard rates, the faster they
recovered from the Great Depression
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.3 - Economic Performance and
Degree of Exchange Rate Depreciation
During the Great Depression
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The Bretton Woods System
• The Bretton Woods System was the
result of an international monetary
conference that took place in 1944
• Three principles guided this system
– in ordinary times, exchange rates should
be fixed
– in extraordinary times, exchange rates
should be changed
– an institution was needed to watch over
the international financial system
• the International Monetary Fund (IMF)
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The Bretton Woods System
• The Bretton Woods System broke
down in the early 1970s
– the U.S. found itself with a large trade
deficit and sought to devalue its currency
• Since then, the exchange rates of the
major industrial powers have been
floating exchange rates
– fluctuate according to supply and
demand
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
How a Fixed Exchange Rate
System Works
• A fixed exchange rate is a
commitment by a country to buy and
sell its currency at fixed, unchanging
prices (in terms of other currencies)
– the central bank or Treasury must
maintain foreign exchange reserves
– these reserves are limited
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How a Fixed Exchange Rate
System Works
• If there is a high degree of capital
mobility, the real exchange rate is set
by
  0 - r (r - r f )
• The higher the interest rate
differential in favor of the home
country, the lower is the exchange
rate
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.4 - The Real Exchange Rate,
Long-Run Expectations, and
Interest Rate Differentials
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How a Fixed Exchange Rate
System Works
• If capital is highly mobile and the
fixed exchange rate (*) is lower than

– foreign exchange speculators will want to
sell the home currency for foreign
currency
• the government spends down its reserves
– to keep the exchange rate at *, the
central bank must lower interest rates
• monetary policy no longer can play a role in
domestic stabilization
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.5 - Domestic Interest Rates Are
Set by Foreign-Exchange Speculators
and the Exchange Rate Target
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
How a Fixed Exchange Rate
System Works
• The central bank must set the
domestic real interest rate equal to
0 -  *
r r 
r
f
– an increase in foreign interest rates (rf )
requires a point-for-point increase in
domestic interest rates
– an increase in foreign exchange
speculators’ views of the long-run value
of the exchange rate (0) requires an
increase in domestic interest rates
15-26
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.6 - Effect of Foreign Shocks under
Fixed Exchange Rates
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How a Fixed Exchange Rate
System Works
• If capital mobility is low
– the exchange rate is also affected by the
speed at which the government is
accumulating or spending its foreign
exchange reserves (R)
  0 - r (r - r f )  R  R
– when the government is accumulating
reserves, the value of foreign currency is
higher than it would otherwise be
• it is increasing foreign currency demand
15-28
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.7 - With Limited Capital Mobility a
Central Bank Can Shift the
Exchange Rate by Spending Reserves
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
How a Fixed Exchange Rate
System Works
• If capital mobility is low
– the central bank can use monetary policy
for domestic disturbances
• this is limited by the sensitivity of exchange
rates to the magnitude of foreign-exchange
market interventions performed by the
central bank and by the amount of reserves
– the domestic real interest rate will be
0 -  * R
r r 

 R
r
r
f
15-30
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Benefits of Fixed Exchange
Rates
• Floating exchange rate systems add
risk
– discourages international trade
– makes the international division of labor
less sophisticated
• This is an important reason behind the
decision of most of western Europe to
form a monetary union
– fix their exchange rates against each
other irrevocably
15-31
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Costs of Fixed Exchange
Rates
• Under fixed exchange rates, monetary
policy is tightly constrained by the
requirement of maintaining the
exchange rate at its fixed parity
• Fixed exchange rates also have the
disadvantage of rapidly transmitting
monetary of confidence shocks
– interest rates move in tandem all across
the world in response
• Fixed exchange rates also make largescale currency crises more likely
15-32
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Fixed or Floating Exchange
Rates?
• Is it more important to preserve the
ability to use monetary policy to
stabilize the domestic economy rather
than dedicating monetary policy to a
constant exchange rate?
• Is it more important to preserve the
constancy of international prices and
thus expand the volume of trade and
the scope for the international division
of labor?
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Fixed or Floating Exchange
Rates?
• Economist Robert Mundell argued that
the major reason to have floating
exchange rates is that they allow
adjustment to shocks that affect two
countries differently
– this benefit would be worth little if two
countries suffered the same shocks and
reacted to them in the same way
– this benefit would also be worth little if
factors of production are highly mobile
15-34
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The European Currency
Crisis of 1992
• After reunification with East Germany,
the West German government
undertook a program of massive
public investment
– this shifted the IS curve out
– the German central bank raised interest
rates to keep inflation under control
15-35
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.8 - German Fiscal Policy and
Monetary Response in the Early 1990s
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The European Currency
Crisis of 1992
• The increase in interest rates
generated a rise in the German
exchange rate vis-à-vis the dollar and
the yen
– exports fell
• Other countries in western Europe had
fixed their exchange rates to the
German mark as part of the European
Exchange Rate Mechanism
15-37
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The European Currency
Crisis of 1992
• The rise in German interest rates
meant that these western European
countries were required to raise
interest rates as well
– the required interest rate increase
threatened to send the other European
countries into a recession
15-38
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.9 - Effect of German Policy on
Other European Countries
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The European Currency
Crisis of 1992
• Foreign exchange speculators did not
believe that these western European
governments would keep this promise
to maintain the fixed exchange rate
parity when unemployment began to
rise
– 0 rose which caused an additional rise in
the domestic real interest rate required to
maintain exchange rate parity
ε0 - ε *
r r 
εr
f
15-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The European Currency
Crisis of 1992
• Different governments in western
Europe undertook different strategies
– some spent reserves in the hope that it
demonstrated their commitment to
maintaining the exchange rate parity
– some tried to demonstrate that they
would defend the parity no matter how
high the interest rate needed to be
– some abandoned the fixed exchange rate
and let their currencies float
• The end result was the formation of
the European Monetary Union
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Mexican Currency Crisis
of 1994-1995
• The Mexican currency crisis was a
surprise to most economic analysts
– the government’s budget was balanced
– the government’s willingness to raise
interest rates was not in question
– the Mexican peso was not overvalued
• The peso lost half of its value in four
months starting in December of 1994
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Mexican Currency Crisis
of 1994-1995
• Concerns about political stability
reduced foreign exchange speculators’
estimates of the long-run value of the
peso and raised their assessment of 0
– the Mexican government spent $50 billion
in foreign reserves and eventually ran out
• it devalued the peso and let it float against
the U.S. dollar
• the rise in  caused a further increase in 0
• the value of the Mexican government’s debt
also increased, which led to further increases
in 0
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Mexican Currency Crisis
of 1994-1995
• The Mexican government had two
options
– it could raise interest rates
• the level of interest rates required would
produce a Great Depression in Mexico
– it could keep interest rates low and let
the value of foreign currency rise much
further
• Mexican companies and the Mexican
government would be unable to pay their
dollar-denominated debts
• Mexico’s foreign trade would fall drastically
15-44
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The Mexican Currency Crisis
of 1994-1995
• The U.S. made direct loans to Mexico
– these loans built Mexico’s foreignexchange reserves back to a comfortable
level
• this allowed domestic interest rates to remain
relatively low
– the Mexican government was also able to
refinance its debt
• confidence was restored that the Mexican
government would not be forced to resort to
default or hyperinflation
15-45
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.10 - Mexico’s Nominal Exchange
Rate: The Value of the U.S. Dollar
in Mexican Pesos
15-46
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The East Asian Currency
Crisis of 1997-1998
• In mid-1997, foreign investors began
to worry about the long-run
sustainability of growth in East Asia
– they began to change their opinions of
the fundamental long-term value of East
Asia’s exchange rates (0)
• the value of the currencies fell causing a
further change in 0
15-47
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The East Asian Currency
Crisis of 1997-1998
• It also became clear that many of
East Asia’s banks and companies had
borrowed heavily abroad in amounts
denominated in dollars or yen
– these loans had been used to make nonprofitable investments
– this lead to further decreases in 0
15-48
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The East Asian Currency
Crisis of 1997-1998
• There was a vicious cycle created
– each decline in the exchange rate raised
the burden of foreign-denominated debt
and raised the probability of bankruptcy
– each rise in the perceived burden of
foreign-denominated debt caused a
further loss in the value of the exchange
rate
• The IMF stepped in with loans to
boost foreign exchange reserves
– promises to improve banking regulation
were made in return
15-49
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.11 - Exchange Rates During the
Asian Currency Crisis
15-50
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 15.11 - Exchange Rates During the
Asian Currency Crisis
15-51
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Managing Crises
• The exchange rate equation offers a
country a menu of choices for its
value of the real exchange rate ()
and its value of the domestic real
interest rate (r)
ε  ε 0 -  (r - r )
f
– the higher the domestic real interest rate,
the more appreciated is the exchange
rate
15-52
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Managing Crises
• If international investors suddenly
lose confidence in the future of the
country’s economy, the menu of
choices that the country has
deteriorates
– if the domestic real interest rate is to
remain unchanged, the exchange rate
must depreciate
– if the exchange rate is to remain
unchanged, the domestic real interest
rate must rise
15-53
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Managing Crises
• Because a large rise in domestic real
interest rates will likely create a
recession, letting the exchange rate
depreciate seems like the logical
policy choice
– throughout the 1990s, investors reacted
negatively when the exchange rate
depreciates
– this seems especially dangerous when
businesses and governments have
borrowed abroad in foreign-denominated
debt
15-54
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Chapter Summary
• For most of the past century, the
world has operated with fixed
exchange rates--not, as today, with
floating exchange rates
• Under fixed exchange rates monetary
policy has only very limited freedom
to respond to domestic conditions
– the main goal of monetary policy is that
of adjusting interest rates to maintain the
fixed exchange rate
15-55
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Chapter Summary
• A country would adopt fixed exchange
rates to make it easier to trade by
making foreign prices more
predictable and less volatile
– fixed exchange rate systems increase the
volume of trade and encourage the
international division of labor
15-56
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• In the past generation, most countries
have concluded that the freedom to
set their own monetary policies to
satisfy domestic concerns is more
important than the international
integration benefits of fixed exchange
rates
– an exception is western Europe, which is
in the process of permanently fixing its
exchange rates via a monetary union
15-57
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Chapter Summary
• Wide swings in foreign exchange
speculators’ views of countries’ future
prospects have caused three major
currency crises in the 1990s
– such currency crises were greatly
worsened by poor bank regulation and
other policies that threatened to send
economies subject to capital flight into a
vicious spiral ending in depression and
hyperinflation
15-58
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.